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Monday, December 2, 2013

Forgone Consumption

People tie themselves up in knots trying to compare RRSPs to TFSAs. Even well-known author and newsletter publisher Gordon Pape has some difficulty. The idea of forgone consumption helps to simplify things.

It’s important to understand how much you’re really saving when you put money in registered accounts. With TFSAs, the situation is simple. If you deposit $3000, then you’ve saved $3000.

RRSPs are more complex. If you’re in a 40% tax bracket and deposit $5000 in an RRSP, you’ll get $2000 back in taxes. Your forgone consumption is only $3000. RRSPs are easier to understand if you think in terms of only having saved $3000. Think of the other $2000 as belonging to CRA.

Suppose that over 30 years your money grows by a factor of 10. Your TFSA now holds $30,000. In the RRSP, your part has grown to $30,000 and CRA’s part has grown to $20,000. If you withdraw $10,000 from your RRSP and your tax rate is still 40%, you’ll get to keep $6000 from your part and CRA will get $4000 from its part. This shows that if your tax rate stays constant, the part of your RRSPs savings that represents your forgone consumption grows at the same pace as your TFSA savings.

The main consideration that tips the scale in favour of one registered plan or the other is changes in your tax rate. RRSPs look better when your retirement tax rate is lower than it was when you worked. TFSAs look better if your tax rate increases in retirement.

There are other considerations that affect the RRSP to TFSA comparison, such as differences in withholding taxes on U.S. dividends and the Home-Buyer’s Plan, but the main concern is tax rates.Withholding Taxes on U.S. Dividends

The idea of forgone consumption was explained on page 278 of the 2008 federal budget as well as by Gordon Pape in the third edition of his book Tax-Free Savings Accounts – How TFSAs Can Make You Rich. Unfortunately, Pape fails to use the idea of forgone consumption correctly in recommending whether to hold U.S. dividend-paying stocks in an RRSP or a TFSA.

When you hold U.S. stocks in a non-registered account, the U.S. withholds a 15% tax on dividends. Because of a tax treaty between Canada and the U.S., this withholding tax does not apply to RRSPs. Unfortunately, the U.S. does not recognize TFSAs as retirement savings. Pape explains, “Inside a TFSA, the dividends will be taxed at only a 15 percent rate.”

Pape goes on to say “That actually may be a better deal than holding the U.S. shares in an RRSP or RRIF, and that’s because withdrawals from those plans are taxed at your marginal rate.” This analysis is wrong. When you properly account for forgone consumption, holding the U.S. shares in an RRSP works out better than holding them in a TFSA.

So here’s the scenario: you’ve got savings in both an RRSP and a TFSA and plan to hold some Canadian and U.S. stocks. The question is which account should hold the Canadian stocks and which one should hold the U.S. stocks.

Remember that an RRSP holds not only your forgone consumption but also CRA’s share. Based on a 40% tax rate, if you hold 300 shares of a U.S. company in your TFSA, you could have held 500 shares in your RRSP (300 shares for you and 200 shares for CRA). If the shares pay a $1 per share dividend, the TFSA would grow by US$300 less 15%, or US$255. In the RRSP case, your part grows by US$300, and CRA’s part grows by US$200; you end up with US$45 more in the RRSP case. It may be galling to grow money for CRA, but you’re still better off with U.S. stocks in your RRSP instead of your TFSA.

Contribution Limits

Pape observes that while the 2013 contribution limit for TFSAs is only $5500, “the maximum allowable RRSP contribution for high-income earners in 2013 is $23,820.” This is true enough, but a little misleading. An Ontario earner who is allowed the maximum RRSP contribution is in at least the 43.41% tax bracket. His forgone consumption on a $23,820 RRSP contribution is only $13,480. This is still quite a bit more than the TFSA limit of $5500, but the gap is smaller than it first appears.

Of course, this difference is for high-earners. An Ontarian making $40,000 is in a 20.05% tax bracket and has an RRSP contribution limit of $7200. The forgone consumption on this size of RRSP contribution is $5756, which is not much different from the $5500 TFSA contribution limit. Of course, lower earners need to be wary of having a much higher effective tax rate in retirement than they had while working because of income-tested government benefits like the GIS. Low-income earners are usually better off saving in a TFSA.

Conclusion

The concept of forgone consumption is important for making sensible choices about contributing to RRSPs and TFSAs and for choosing investments within these accounts.

5 comments:

I find it tricky working through the numbers for TFSAs and RRSPs because of the different taxation effects.

In particular, I tend to over-estimate the hit our RRSPs will take when we have to start drawing out from them. But I find I feel more comfortable over-estimating because the government keeps throwing more wild cards into the equation: for example, now the ON government has that floating rate "tax" to help cover health care costs. If we take money out of our TFSA it won't result in us having to pay more for health care. If we take money out of our RRSP it likely will. Some day I need to check what the rules are around the government drug benefits for seniors too. I suspect we won't qualify for them because of RRSP income, if there is an income cap.

@Bet Crooks: Halving your RRSP funds may be a little pessimistic, but it's better than dreaming of getting the whole amount. If I retire short of 65, I'll need to figure out the best way to draw RRSP funds to manage my income to keep it smooth between before age 65 and after.

At least there are TFSAs now, so if you decided to draw out more before 65/other pensions kick in, and if you didn't need to spend it, you could re-invest it in a sheltered environment. I think it must have been brutal trying to weigh between taking it out in "low/no income years" between say 55-65, and leaving it in so the growth is tax-sheltered for longer.